On Feb. 23, the Honourable Ralph Goodale, federal Minister of Finance, tabled his second budget. The budget contains a number of positive announcements relating to employers' HR interests — in particular, the elimination of the foreign content limit, and an increase in the contribution and maximum benefit limits for registered retirement savings and pension plans.
Elimination of the foreign content limit
The budget eliminates the 30 per cent foreign content limit for registered retirement savings and pension plans, effective for 2005 and subsequent years. Registered plan assets may now be invested in eligible foreign investments without limit.
This will allow pension funds to create internationally diversified investment portfolios and will be welcome news to plan sponsors that wish to increase foreign content. The Canadian equity market represents less than 3 per cent of the world's market capitalization. To invest in a well-diversified portfolio of leading global corporations, Canadian investors must look outside Canada. As plan sponsors increase the proportion of their funds invested outside Canada, they will need to focus more on managing the currency risk inherent in such investments.
Eliminating the foreign content limit will permit plan sponsors to do away with complex and expensive devices previously used to get around these limits. Synthetic foreign equity funds, stacked pooled fund trusts, clone funds and total return swaps all had a cost associated with them. Eliminating the cost of these devices (more than one per cent per year in the case of some funds) will improve returns from these investments. Eliminating the foreign content limit will also do away with the cost of monitoring for Income Tax Act (ITA) compliance.
Increases to contribution and maximum benefit limits, for tax-assisted retirement savings
The budget announced modest, but nonetheless welcome, increases in the registered plan limits beyond the limits already announced in the 2003 budget. For defined benefit registered pension plans (DB RPPs), defined contribution registered pension plans (DC RPPs), and registered retirement savings plans (RRSPs). See table for new limits.
The budget proposals represent a nine to 13 per cent increase in retirement savings room, assuming annual average wage growth in the range of two to three per cent for the next several years.
For HR managers, the implications of the increased registered plan limits will depend on each plan's design.
Defined benefit registered pension plans:
For many DB RPPs, plan documentation automatically reflects any future changes to legislated limits. The new limits will increase costs for employers that sponsor plans structured this way. (The same is true for employers whose plans do not automatically incorporate the higher limits, but who amend plans to reflect new limits.)
For underfunded pension plans, the increase in liabilities may have a modestly negative impact on transfer ratios; this may affect the payment of termination benefits, the timing of actuarial valuation reports, and (if applicable) the amount of the assessments payable to Ontario's Pension Benefit Guarantee Fund (PBGF).
Increases in the defined benefit limit will be retroactive. Ordinarily, retroactive increases in the defined benefit limit, in excess of increases in the average wage, would result in a past service pension adjustment (PSPA) — which would reduce a member's RRSP contribution room.
Amendments to the Income Tax Regulations will be released later this year to provide guidance on situations where benefits can be improved to reflect the new defined benefit limit without reducing RRSP contribution room.
Defined contribution registered pension plans, RRSPs and deferred profit sharing plans:
In situations where employers cap contributions to a DC arrangement at the tax sheltering limits — or top up DC amounts in excess of the tax sheltering limits through an unfunded (or notional) DC account — the proposals will increase the cash cost, since more will now be funded through the registered DC vehicle. If the top-up arrangement is funded, however, the cost increase for the registered plan will be offset by a cost reduction for the top-up plan.
For employers considering a conversion of their retirement plan from a DC to a DB design (an idea which has gained some attention, following several such conversions in recent years), the retroactive increase to the DB RPP limits will allow more room for creating or restoring DB entitlements.
Supplemental employee retirement plans (SERPs):
The increased limits will allow employers to shift pension liabilities and costs from SERPs to registered plans. Employers that have set up SERP funding or security arrangements may now wish to review those arrangements, in light of the increased limits, as SERP assets may now be more than required. For employers that do not currently fund or otherwise secure the SERP, the increased limits may, in some cases, reduce the pressure to do so.
For “flexible” pension plans
: For employers with defined benefit plans that allow employees to make optional contributions to buy ancillary benefits — often called “flexible pension plans” — higher income employees will now have a larger pension to "flex." Employers might consider advising employees to review their contribution level in light of the higher limits.
The higher limits also raise communication issues. Employers should consider how best to communicate the impact of the new limits to plan members. Payroll and pension administration systems will also need to be updated to reflect the new limits.
The increased limits were announced, in part, to address the disparity between Canadian registered plan limits and the comparable limits in the United States, which affect the cost to employers of attracting and retaining mobile employees.
While the proposals are a positive development, Canada's limits on tax-assisted retirement savings are still substantially more restrictive than those of our major trading partners with private pension systems (United States and the United Kingdom).
As was the case in 2004, the 2005 budget did not contain any announcements concerning tax pre-paid savings plans (TPSPs), which had first been discussed in the 2003 budget. In a TPSP, contributions would not be deductible, but investment returns and plan withdrawals would not be taxable.
This would be similar to the Roth IRA available in the United States — and would represent a welcome enhancement to the Canadian retirement savings regime. In addition to supplementing retirement income, it could also be a useful vehicle for pre-funding post-retirement benefits.
Relaxation of RPP investment rules regarding income trusts
The 2004 budget had proposed to limit the amount that registered pension plans may invest in business income trusts. Income trusts are unincorporated businesses that provide participation in the equity and debt of a company through units in a trust.
The structure of income trusts allows for the distribution of pre-tax income to the unit holders. The income is not taxed at the corporate level but only in the hands of the unit holders. Since pension funds do not pay income tax, there is some concern that the corporate tax base may be eroded as more plans invest in these vehicles.
As a result of stakeholder concerns expressed after the 2004 budget about the impact of these proposals, the government decided to suspend the implementation of this measure. The 2005 budget indicates that the government will consult stakeholders on tax issues associated with income trusts and other flow-through entities.
Pension funds, for the most part, have not invested in income trusts due to the historic lack of a clear statutory limitation on unit holders' liability (unlike that provided to holders of common shares). This issue has recently been addressed in provincial legislation. Also, Standard and Poor's has announced that income trusts will be added to the S&P/TSX Composite Index.
These measures, in conjunction with the 2005 budget proposal, may lead more pension plan sponsors to consider investing in income trusts.
Greater flexibility for pensioners holding life income funds (LIFs)
Currently, regulations under the federal Pension Benefits Standards Act (PBSA) require that holders of LIFs must use any remaining LIF funds to purchase an annuity from an insurance company at age 80. The budget proposes to increase the financial flexibility of individuals who fall under the jurisdiction of the federal PBSA, by eliminating this requirement.
Employers in the federal jurisdiction that offer financial or retirement planning education for employees may wish to communicate the impact of this change to their employees.
Possible changes to the Canada Pension Plan (CPP)
The 21st Actuarial Report on the Canada Pension Plan, tabled in Parliament in December 2004, states that the CPP is financially sustainable for at least the next 75 years.
As part of the next triennial review of the CPP, the budget indicates that the federal government, in consultation with the provinces, will consider a number of possible changes to the CPP, including adjustments for postponed retirement and the requirement to stop working as a condition for early pension commencement, similar to discussions recently initiated by the Quebec government regarding the Quebec Pension Plan.
The budget documents note that there have been significant changes in the work and retirement patterns of Canadians since inception of the CPP in 1966, including "taking varied paths to retirement." The next triennial review will consider changes to reflect these developments. This review may include measures such as phased retirement.
While the government’s comments in the 2005 budget do not prompt any immediate action steps for employers, HR managers should watch for further developments following the next triennial review.
A new approach for EI rate-setting
The government proposes to introduce a new permanent rate-setting mechanism for Employment Insurance based on principles originally described in the 2003 budget:
•The expected premium revenue should correspond to the expected program costs (the premium rate should be set at a break-even level).
•Premium rates should be set transparently, and on the basis of independent expert advice.
•The premium rate-setting methodology should mitigate the impact of the business cycle.
•Premium rates should be relatively stable over time.
The new rate-setting mechanism is now expected to be in place in time to set the rate for 2006. To provide rate stability in the transition period, the government has said the EI rate for 2006 and 2007 will not exceed the current rates of $1.95 for employees and $2.73 for employers, per $100 of insurable earnings. Future premium increases will be limited to 15 cents per year for employees and 21 cents per year for employers.
For employers, the greater accountability suggested by the proposed rate-setting principles will be welcome, as will the proposal for ensuring rate stability during the period of transition.
The budget also indicates that the federal government will announce details of benefit changes under EI in the near future. As well, EI premium rates may be adjusted in Quebec if the federal government and the province reach an agreement regarding the province’s proposal to provide maternity and parental insurance benefits.
Expansion of the medical expense tax credit
The list of items eligible for the medical expense tax credit will be expanded, effective for 2005, to reflect advancements in technology and medical treatments. New items include medical marihuana, and drugs and devices purchased under Health Canada's Special Access Program (SAP).
Under the SAP, special access to products can be requested in emergency cases or when conventional therapies have failed, are unsuitable or are unavailable.
A liberalized definition of “medical expenses” under the ITA could have implications for employer-sponsored health benefit plans, which are usually designed to qualify as “private health services plans” (PHSPs).
To be tax effective, PHSPs are limited to providing medical and dental benefits that would otherwise qualify for the medical expense tax credit. The wording of many PHSP policies is such that an expansion of the list of items eligible for the medical expense tax credit would automatically expand the list of eligible expenses under the employer-sponsored plan.
Employers may wish to consider whether they want to extend such coverage under their insured group benefit plans. This measure will also expand the list of eligible expenses for employers that provide health-care spending accounts for employees; the administration of group benefit plans that have a health-care spending account will need to be revised to reflect these changes.
Extension of special pension provisions for public safety occupations
The budget proposes to extend the special maximum pension and early retirement rules to a broader range of public safety occupations, effective Jan. 1, 2005.
Paramedics will be added to the list of occupations (which currently includes commercial airline pilots, air traffic controllers, firefighters, police officers and corrections officers) for which employers can provide unreduced early retirement benefits at an earlier age than the tax rules normally allow.
Also, for all individuals in the specified public safety occupations, employers will now be allowed to provide a pension benefit formula of up to 2.33 per cent of pay per year of service, integrated with the C/QPP; previously, this special provision was only available for firefighters.
For governments, agencies, and certain private sector organizations that employ individuals in the expanded list of public safety occupations, these proposals may create an expectation that existing pension plan provisions will be enhanced, leading to increased pension costs for such employers.
Enhanced deposit insurance coverage limit
The government is increasing the deposit insurance coverage limit from $60,000 for insurable deposits to $100,000, effective immediately. This will enhance the security for certain eligible investments made by members of DC pension and savings arrangements, such as GICs and term deposits.
And, to conclude …
The government confirmed $41.3 billion dollars of new federal health-care funding over 10 years, as previously announced at the September 2004 first ministers' meeting. This increased funding may indirectly benefit employers that sponsor health-care plans.
The budget forecast for 10-year federal government bond yields calls for rates to remain essentially unchanged from 2004 to 2005, and then to increase by 0.5 per cent in 2006 and by a further 0.5 per cent over 2007-2009. For the next several years, the forecast bond yields in the 2005 budget are lower than the government had previously anticipated in the March 2004 budget and in the November 2004 economic and fiscal update.
From a pension perspective, a continuing low interest rate environment will mean that funding and accounting costs for defined benefit pension plan sponsors will remain relatively high, investment returns for those members of defined contribution plans who choose to invest in term deposits and GICs will remain modest, and pension payments for those members of defined contribution plans who choose to buy annuities upon retirement will remain relatively low. The attractiveness of both DB and DC plans suffers — albeit in different ways — in a low interest rate environment.
C. Ian Genno is a consulting actuary and principal in the Toronto office of Towers Perrin. This article was prepared with the assistance of colleagues in the Toronto office.